JJ MacNab, CFP, CLU has 12 years of experience in the estate, charitable, insurance and financial planning industry. She specializes in the area of advanced estate planning for high net worth individuals, family businesses, and family offices. MacNab provides fee-based analytical services to nonprofit organizations, attorneys, CPAs, and trust officers. She is one of 33 Licensed Life Analysts in the state of California and performs fee-based insurance due diligence and due care for charities, clients, and professional advisors.

Viatical Settlements: Myths and Misconceptions

It seems that everywhere you look, viatical settlement companies are advertising high payout rates to policy owners, high guaranteed returns to investors, and high commissions to advisors. Their marketing efforts target everyone--from seniors to charities, from the terminally ill to the completely healthy, from advisors to hospice social workers--promising unparalleled financial, estate, and income tax benefits. At the same time, the news is full of stories of complicated scams, lost investments, and unregistered rogue companies.

With so much conflicting information, the viatical settlement industry seems more like a landmine than a gold mine, and as more of our clients learn about this planning technique, as advisors, we will need to become better equipped to handle their questions. It takes time and patience to uncover the legitimate firms, and to cull the real benefits to the client from all of the persuasive sales hype.

Based on the analysis that follows, those that are considering the use of a viatical settlement--either to sell an existing policy or to invest their money--should exercise caution. For the elderly or terminally ill, this planning tool should be considered primarily if finding a source of cash is essential, and only after all other planning options have been examined. From the investment side of the equation, only the more sophisticated, or accredited, investor who understands the inherent risks, and can tie up potentially long term funds in an illiquid asset, should consider this arrangement.

A Brief History

The word viatical comes from the Latin viaticum meaning "provisions for a journey," and considering that the early viatical settlements provided much needed cash to terminally ill policyholders, the name is appropriate. A viator is a policy owner who sells, or viaticates, his/her life insurance policy death benefit to an investor, a pool of investors, or a viatical funding firm.

The sale of a life insurance policy to a third party is not a particularly modern concept, but the viatical settlement sector only began organizing as an industry in the mid 1980s. A small handful of funding firms, backed by sizable loans and credit lines, recognized that a rising number of AIDS patients were cash poor but held large life insurance policies. These terminally ill insureds had relatively short but predictable life expectancies, and they faced a dire need for immediate cash to pay for expensive medical treatments, experimental drugs, and basic living expenses.

As long as these AIDS patients managed to find and work with a reputable viatical funding firm who offered them a fair price for their policies, based on a realistic life expectancy, this new planning option was extremely effective. Unfortunately, as word spread of the high potential profits to be made, several less ethical firms began taking advantage of the dying insureds, offering only a fraction of a policy's true value by making overly optimistic mortality assumptions, and in some cases, accepting ownership of the policies but never paying the insureds.

In response to the viatical industry, in 1990, insurance companies began offering a new option to policyholders called an Accelerated Death Benefit (ADB). An ADB is often added as a no-cost rider to current life insurance policies, although some companies charge an annual fee. This rider pays a percentage of the death benefit to the policy owner if an insured is terminally ill (usually defined as having a life expectancy of less than 12 or 24 months). At the policy holder's death, the remaining percentage of the death benefit, sometimes reduced by a small fee, is paid to the policy owner's named beneficiary. In 1996, the viatical industry boomed with a sudden rush of new companies, some with open disregard for state security, insurance laws, and registration requirements. These new companies usually did not purchase policies for their own portfolios, but rather acted more like a limited partnership, or mutual fund, courting investors to raise the funds to purchase large numbers of policies. Rather than risking their own money on the life expectancies of the individual insureds, these firms passed this risk to the individual investors and instead, charged a sizable fee for their services. Considering that by 1996, new drug treatments had made it increasingly difficult to estimate accurately the life expectancy of the average AIDS patient, this shift in the industry from funding firm to marketing firm was not surprising. Furthermore, investors were clamoring to get involved in the industry's highly touted profits, and lack of regulation resulted in little or none of the inherent underlying risk ever being disclosed to these investors.

Viatical brokerages sprang up to meet the demands of these new investors, acting as intermediaries between buyers and viators. With this increased market demand, some of the older, more established funding firms also began offering these investments to the public.

The viatical marketplace is once again going through a change. To meet the growing demand of investors, the funding and marketing firms have had to widen their purchase criteria. In addition to buying policies from the terminally ill, they now court insureds with relatively minor illnesses, and in some cases, completely healthy insureds over a certain age with larger insurance policies.

Planning From A Viator's Point Of View

As mentioned earlier, viaticating a life insurance policy can be a very effective way for a terminally ill insured to raise much needed cash during his/her final months. This cash is unrestricted and can be used to pay for everything from medical expenses to a trip around the world. However, there is a high cost associated with this planning technique and all other options should be considered, all tax consequences weighed, and the decision should be made as part of a comprehensive plan.

Myth #1: An insured who is terminally ill should viaticate.

Before signing away his/her contract, a terminally ill insured should consider all other potential planning options:

1) Keep the policy in force. It is important to remember that the viatical settlement company expects to make double digit, and in some extreme cases, triple digit returns on its investments. If the insured has cash available from other assets such as a retirement plan, an equity line, or a reverse mortgage on the home, these should be exhausted before using a viatical settlement. If possible, the double-digit profit should be passed to beneficiaries, and not to nameless investors.

2) Borrow from the policy's cash value. If only a limited amount of cash is needed, the policyholder should consider withdrawing or borrowing these funds from the policy. To minimize tax consequences and loan interest, the optimal solution would be to withdraw funds from the policy until the cost basis is reduced to $0, and then take policy loans to meet the remaining cash need.

3) Accelerated death benefit. Advisors should research this option for all terminally ill clients who are considering viaticating their policies.

4) Combine an accelerated death benefit with a viatical settlement. Accelerated death benefit riders often limit the amount of cash that can be withdrawn from a policy. For example, an insured with a $200,000 policy has been diagnosed with a 12-month life expectancy. The policyholder has received an offer of 70% from a viatical settlement company, but the insurance company only pays out a lifetime benefit of 50% of the death benefit. If the policyholder withdraws the 50% ADB amount of $100,000, and viaticates the remaining 50%, he will end up with a total of $170,000, which is equivalent to an 85% payout rate.

5) Sale to an heir or relative. If an accelerated death benefit rider is not available, the policyholder should consider selling the policy to a child or heir. Again, if the viatical settlement company is anticipating a 25% return on its investment, for example, why not pass that profit on to heirs instead of strangers.

6) Viaticate. For the terminally ill client, viatication should be the last resort. If this option is to be explored further, a number of offers should be obtained from different viatical companies and brokers and the best offer used for all comparison planning. While a viatical company may advertise that they pay 85% of the death benefit, once an actual offer is obtained, this figure may be closer to 70%, 60%, or even 50%.

Myth #2: A viatical settlement pays more than an accelerated death benefit.

The accelerated death benefit is probably the most misunderstood, and misrepresented, concept in this planning field today. Despite the marketing promises made by various viatical settlement companies, a typical accelerated death benefit rider will pay more, and in some cases, much more, in total benefit than a viatical settlement.

An accelerated death benefit rider, sometimes referred to as a living benefit, accelerated benefits option, or benefit advance endorsement, pays a percentage of the death benefit to a terminally ill insured during his/her lifetime. At death, the remaining death benefit, sometimes reduced by a small service fee, is paid to the policyholder's named beneficiary. This fee can range from a flat dollar amount, such as $250, to a small percentage of the death benefit (3%-4%).

An insurance company will require that the insured have a limited life expectancy that varies by company and policy type, between three months and 24 months. The payout percentage ranges from 25% to 100%, and some companies impose a cap on the maximum amount that will be paid out under this rider. The following shows the ADB riders for four insurance companies.

Exhibit A

Company A

Company B

Company C

Company D

Life Expectancy

6 months

12 months

6 months

3 months

Payout Amount

100% of the death benefit up to $250,000, remainder, if any, to beneficiaries at death.

50% of the death benefit, remainder to beneficiaries at death.

80% of the death benefit up to $500,000, remainder to beneficiaries at death.

100% of the death benefit.

Administrative Fee

$300

$0

3%

$500

One viatical company's sales material makes the comparison that "our viatical settlement will pay you as much as 80% of the Death Benefit, while an ADB rider will pay as low as 25%." First of all, it is never appropriate to compare the maximum possible payout for one planning technique with the minimum possible payout for another. Furthermore, this statement ignores that with an ADB rider, any percentage not paid out during lifetime is paid at death to the beneficiaries, but with a viatical settlement, it is instead profit for the investors.

Another viatical company contends that "only 10% of insurance companies have this option." While this statement may be true for all insurance companies, most of the major insurance companies (the ones with which our clients are most likely to have purchased insurance) offer the rider.

Yet another claim is that the insurance company will restrict the use of funds while money received from a viatical settlement is unrestricted. Not only is this statement untrue, but state law specifically prohibits insurance companies from restricting the use of funds.

Some companies contend that an ADB rider takes much longer than a viatical settlement to pay out benefits. In fact, the reverse is true, and the insurance companies are usually faster to pay these claims than a viatical company.

Myth #3: Our company will pay you 85%, so sign up today!

The sales brochures from various viatical settlement companies promise high payout rates of up to 80% and 85%. These figures have no real meaning until your client obtains a written offer from a variety of companies based on his/her actual health circumstances and policy information. Several factors will affect this offer including projected life expectancy, the quality of the insurance carrier, the type of insurance contract (term, universal life, etc.), the premium paying status of the policy (paid up, minimum funded, vanished, for example), and the size of the policy.

Perhaps the most common mistake made by prospective viators and their advisors is that they only underwrite with one viatical company or with one broker. They may choose the "oldest" company or the "biggest" company, or the one that promises to donate the largest percentage of profits to charity but, unfortunately, in the long run, none of these factors take into account that this is a seller's market, and if a potential viator seeks offers from a number of companies--at least six--the companies will attempt to outbid each other for the business. This costs the policyholder nothing, the paperwork can be alleviated by either using brokers or a generic application and authorization form, and this bidding system often results in a cash settlement that is several thousand dollars more than the offer they would have received had they gone through just one company.

Some viatical companies have made various attempts to prevent viators from shopping for multiple offers. These efforts include: 1) having the viator sign an exclusivity agreement, agreeing not to contact any other viatical companies; 2) sending the viator a sales contract before medical underwriting even begins, claiming that this will result in the funds being paid out faster; 3) competition bashing; and 4) sales pressure. It is important to ignore these tactics since offers between viatical companies can vary by as much as 25%, and there is nothing to be gained by the viator talking with only one company.

In choosing which companies to approach, a viator should consider the following:

1) Are they licensed in the policyholder's state? One company advertises that they are one of the "largest, oldest, and most respected" viatical companies in the nation. They are also practicing illegally, not having met the licensing requirements in any of the states that require licensing. The license status of every viatical company under consideration should be verified by the state Department of Insurance. Unfortunately, less than half of the states have viatical regulation at this time (CA, CT, FL, IL, IN, KS, LA, ME, MI, MN, MT, NC, ND, NH, NY, OK, OR, TX, VT, VA, WA, WI).

2) Are they eligible to do business in at least two of the better regulated states (New York, Washington, and/or Florida)?

3) Does the viator's policy fit the company's size requirement and minimum third party rating requirements?

4) Will the viatical company guarantee confidentiality in writing?

5) Are there any costs involved? There should be no fees to the viator (for example, application fee, due diligence fee, medical underwriting fee, etc.), and in negotiating an offer, the viator should specifically request "net" offers only.

6) If working with a broker, does he/she guarantee, in writing, full disclosure of all offers and fees?

7) Will an escrow account be used, and will the escrow company notify the viator directly when the funds become available? The process takes between four to six weeks from application to cash, and the viator may stop the process at any time without incurring any cost or penalty. Furthermore, once the process is complete, the viator has 15 days (30 days in some states) to change his/her mind and rescind the sale.

Myth #4: Viatical settlements are tax free.

Not all viatical settlements have the same tax consequences. Unless the transaction falls within specified exemptions, the gain recognized from the sale of an insurance contract will be taxed as ordinary income. [IRC § 72(e)]

In 1996, the Health Insurance Portability and Accountability Act (HIPAA) was signed into law, making viatical settlements and accelerated death benefits income tax free for chronically ill and terminally ill insureds. Under prior tax law, any gain from the sale of life insurance was taxed as ordinary income. Under Code Section 101(g), for sales after January 1, 1997, to qualify for this special tax treatment, the insured must have less than two years to live, as determined by a physician. There is no dollar limit on the amount that can pass tax free. While many states have passed laws that mirror the federal law above, some states, however, still impose income tax on both accelerated benefits and viatical settlements.

It is extremely important to note, however, that for the sale proceeds to be pass tax free to the viator, a "qualified viatical settlement provider" must purchase the policy. [IRC § 101(g)]

To qualify, this provider:

1) is a person or company that regularly purchases insurance policies on the lives of terminally ill insureds;

2) must be licensed as such in the state where the insured resides; and

3) must meet the requirements of Sections 8 and 9 of the Viatical Settlements Model Act, issued by the National Association of Insurance Commissioners, as well as the requirements relating to standards for evaluation of reasonable payments in determining amounts paid by the viatical settlement provider.

Exhibit B: Minimum Payment Guidelines of the NAIC

Life Expectancy of Insured

% of Face Value Paid

1-6 months

80%

6-12 months

70%

12-18 months

65%

18-24 months

60%

24-36 months

50%

There are several rogue companies in business today that have not met the state-licensing requirement and do not disclose this problem with prospective viators. Since these companies are not considered "qualified," the surviving families of these terminally ill viators will face substantial, unnecessary income taxes as a result.

HIPAA also carved out an exemption for chronically ill persons to receive benefits tax free, subject to certain limitations. A chronically ill person is someone who has been certified by a physician in the past 12 months:

1) to be unable to perform, as the result of the loss of functional capacity, at least two activities of daily living (eating, toileting, transferring, bathing, dressing, and continence) for at least 90 days; or

2) has a similar level of disability as defined by the Secretary of the Treasury; or

3) requires substantial supervision to protect the person from threats to health and safety due to severe cognitive impairment. For chronically ill persons, amounts paid with respect to a life insurance contract are excludable only if: 1) the payment is for actual costs of qualified long term care that are not defrayed by insurance payments or otherwise; and 2) payment is not made for expenses that are reimbursable under Medicare. In addition, payments made to chronically ill persons on a per diem, or other periodic basis, are excludable but only to the extent that they do not exceed $180 per day, indexed for inflation.

Myth #5: Senior settlements make rich clients richer.

As mentioned earlier, the viatical settlement industry is currently going through another change. New drug treatments have greatly extended the life expectancy for AIDS patients, and an influx of new viatical companies has made competition for buying policies on the lives of the terminally ill more difficult. To meet the rising demand of new investors, the viatical settlement firms have started to aggressively seek out the purchase of larger insurance policies on the lives of elderly insureds, even those that are healthy.

For example, up until 1997, a typical viatical company would have a maximum life expectancy requirement of three to five years before they would consider purchasing a policy. As these contracts became increasingly difficult to find over the past two years, their purchasing criteria expanded to include any insured, healthy or otherwise, over the age of 75 with a death benefit in excess of $500,000. The average viatical payout for these "healthy" contracts ranges from 6% to 40% of the policy's death benefit, depending on the age and health of the insured, the type of policy, and whether or not they are competing for the business with other viatical companies.

Since these new purchases don't provide cash to the terminally ill, some firms refer to them as senior settlements, high net worth settlements, or simply lifetime settlements. The target market for these purchases are affluent seniors, charities, and corporations where a key executive has retired.

As the industry shifts their target market from terminally ill insureds who desperately need cash, to affluent seniors with savvy financial, tax, and legal advisors, the marketing techniques have shifted as well. For the terminally ill market, viatical settlement companies often recruit social workers, funeral directors, and AIDS volunteers to sell their settlements. For the senior settlement marketplace, attorneys, accountants, planners, insurance agents, and planned giving consultants are being recruited.

The following is a brief analysis of income, tax, and estate planning ideas that are being promoted by a variety of viatical companies. This list is not intended to be complete, but it may provide advisors with some ideas and understanding of what our clients will be asking about over the next year or two. Each of these cases has some merit, but other planning options should be considered and analyzed as well. While the viatical settlement companies compare their planning ideas to the worst case scenario--no planning at all--professional estate planners will find that the inherent cost of the settlement will become more transparent as they compare these ideas with other advanced techniques.

Example: A reasonably healthy 75-year-old insured has a $500,000 whole life policy with a $10,000 annual premium that she can no longer afford. If she were to surrender the policy, she'd receive the cash surrender value of $55,000, and if she stops paying the premium, the policy will lapse. A viatical company has offered her $100,000 in cash.

Commentary: The insured should consider several other options before viaticating:

Reducing the death benefit so that it becomes paid up at its current cash value level.

Selling or giving the policy to her family, heirs, or charity.

Liquidating other assets to pay premiums.

Taking out a loan from a bank, business associate, or family member and using the insurance policy as collateral.

Viaticating. The insured, however, should be careful of unintended consequences. The cash payment would cause her Social Security income to become taxable in the year the viatical payment is received, and if she is receiving any means-based entitlements such as Medicaid or food stamps, these benefits would be interrupted as a result of receiving proceeds from a viatical settlement.

Case 2: Insurance Planning--a policyholder has term insurance that is no longer needed.

Example: Mr. A purchased a $500,000 term policy to cover a 10-year note that he has just fully repaid. If he allows the policy to lapse, he'll receive nothing. If he viaticates, he'll receive a cash benefit of $25,000. He has no heirs.

Commentary: While the benefit of viaticating is not extremely high in this scenario, this may be a very good case for it. The client has no heirs, and no need for the insurance.

Case 3: Insurance Planning--substitute for long term care insurance.

Example: Several years ago, Mr. B purchased a $500,000 policy that would put his five children through college if something happened to him. All five children have now graduated and his insurance needs have shifted from life insurance to long term care (LTC) insurance. Rather than canceling the insurance and purchasing a new LTC policy, he's been advised to keep the life insurance, and allow the viatical value of the policy to be his long term care fund.

Commentary: Once again, Mr. B should consider all of his options before making this decision. In particular, he should consider rolling his current policy values into a hybrid universal life/long term care policy, or a deferred annuity/long term care plan to provide additional benefits and guarantees. Self-insuring can be an excellent option, as long as long term costs don't exceed his available funds. Whereas an LTC policy can be purchased to provide an unlimited benefit, the value of the insurance policy is naturally limited, especially if Mr. B requires expensive nursing care and has a long life expectancy.

Case 4: Estate Planning--removing a policy from the estate without triggering the three-year estate inclusion rule.

Example: A 76-year-old client with a two-year life expectancy owns a $500,000 policy. When he dies, his heirs would receive a net amount of roughly $225,000, assuming a 55% estate tax bracket. If he viaticates instead, he could receive $300,000 from the viatical settlement company, and make current cash gifts to his children, grandchildren, and great-grandchildren. According to the viatical representative, the net to heirs would therefore be $300,000--much higher than the original net to heirs of $225,000. He cannot give the policy to his children and obtain the same results because the policy would be included in his gross estate for three years.

Commentary: This is one of the most common analyses currently presented by viatical settlement companies, and it should be noted that they often ignore the cost of such planning (the use of $300,000 in annual exemptions), as well as the fact that there are other, more beneficial alternatives:

If the client has not gone through medical underwriting since becoming terminally ill, and if the insurance policy is not considered paid up, the fair market value of the policy for IRS purposes would be roughly the cash surrender value of the policy, in this case $150,000. Instead of viaticating, the client should consider transferring $150,000 in cash to an intentionally defective trust for the benefit of his children and grandchildren. The trust could then use that money to purchase the life insurance from the insured. The current cost of the planning is roughly half of the example above--the use of $150,000 of annual exemptions--but the net to heirs is significantly higher at $500,000.

Even if the IRS assigns a value of $300,000 to the policy, the benefits of using a defective trust still outweigh those of the viatical settlement. The cost would be higher--the use of $300,000 of annual exemptions plus roughly $50,000 in income tax--but the net to heirs would be significantly higher.

Case 5: Estate Planning--reducing the estate below $650,000.

Example: A 75-year-old client has $510,000 in assets and a $200,000 life insurance policy. According to a viatical company analysis, she should viaticate the policy now and reduce her gross estate to $650,000. As a result, her heirs will not have to file a Federal Estate Tax Return and will receive the entire estate free of estate taxes.

Commentary: Sometimes, doing nothing is appropriate. With the viatical settlement arrangement, if the client receives a 70% payout from the viatical company, her estate would be reduced to $650,000, no tax return would be filed, and the net to her heirs would be $650,000. If the client did nothing, however, her gross estate would be $710,000, and while her children would have to file a tax return and pay roughly $22,000 in taxes, the net amount they would receive would increase by approximately $35,000. This is one case where crunching the numbers could show a discrepancy between what sounds like a good idea and what makes sense from an overall planning point of view.

Example: An irrevocable life insurance trust (ILIT) owns a $1,000,000 policy on the life of Mr. Y. The trust viaticates this policy and receives a cash benefit of $800,000. It then uses this cash to purchase 49% of Mr. Y's company, which has a total value of $2,000,000. Assuming that the minority interest purchased by the ILIT can qualify for a 35% discount, the client would save roughly $192,500 in estate tax overall.

Commentary: While the above planning scenario (outlined in detail in a viatical company brochure) is accurate, it fails to take into account that the client lost $200,000 in value from the insurance policy to gain $192,500 in tax savings. It furthermore ignores that the 49% of the business will not receive a stepped up basis at Mr. Y's death.

A few of the more sophisticated viatical companies have started illustrating the combination of viatical settlements with other highly effective estate planning techniques. The benefits that result, however, are due to the estate planning strategy, not the viatical settlement.

Case 7: Charitable Giving--using the proceeds from a viatical settlement to fund a CLAT.

Example: Dr. Z, a 76-year-old in good health, would like to establish a charitable lead annuity trust at this time. A viatical representative suggested that he viaticate his existing $2,000,000 policy and receive a cash payment of roughly $800,000. He can then use this cash to establish a charitable lead trust with his hospital as income beneficiary, and his children as remaindermen. In this way he can pass the full $800,000 (and any growth in excess of 7% per year) to his children at the end of 15 years, using only $240,000 of his available unified credit.

Commentary: This example is similar to Case #6 above. The benefits from this planning technique come from the use of a CLAT, not the viatical settlement. Since the cost of viaticating is high (60% of the value of the death benefit is lost) and since it unlikely that Dr. Z will qualify again for life insurance due to his age, all other funding methods should be considered first. Alternatively, Dr. Z should consider establishing a testamentary CLAT with the proceeds from the life insurance policy. The benefits to both charity and heirs would be substantially higher.

Case 8: Charitable Giving--viaticating the policy and making a gift to charity.

Example: A client in normal health wishes to make a lifetime gift to charity but needs the income from her current assets. Her viatical advisor recommends that she viaticate her $500,000 life insurance policy and receive a cash payment of $200,000. She can then give $200,000 of other highly appreciated assets to charity, replace these assets with the proceeds from the settlement, and receive an income tax deduction sufficient to offset the ordinary income realized upon the sale of her insurance.

Commentary: The client would probably be better off simply setting up a split-interest arrangement with the charity using her highly appreciated assets to fund a charitable gift annuity or charitable remainder trust. She would receive a current tax deduction for the present value of the gift, and would still have the life insurance policy available for her heirs, or for an emergency fund, should she become terminally ill at some time in the future.

Example: Many charities have recently been approached by viatical salespeople with the advice that they viaticate the policies in their portfolio and use these funds for other investments or charitable purposes.

Commentary: For policies on the lives of terminally ill donors, the charity should recognize that the fair market value of these contracts is substantially higher than the cash surrender value. For an insured with a life expectancy of one year, for example, the NAIC recommends a 65%-70% payout. A charity would be hard-pressed to find another investment that would return 30%-35% in one year and should make every effort to maintain these contracts in good standing. For healthy, but elderly donors, viatical settlement companies are primarily interested in those donors who are over 75, with a death benefit in excess of $500,000. Charities should realize that while smaller policies on younger insureds may not be worth the effort of administration and the commitment to pay future premiums, these larger, older policies are well worth the trouble. In fact, the only policies that senior settlement companies want to purchase are the very ones that charity should value the most in their investment portfolio. Unless a charity faces dire cash flow problems, the use of viatical or senior settlements is not appropriate.

Furthermore, the charity should consider the potential donor relation's problem with viaticating. For example, Mrs. X, age 75, has given her favorite charity a $1,000,000 death benefit policy. The charity decides to viaticate the policy for $450,000 and asks her to sign some forms giving the viatical company permission to obtain copies of all of her medical records. The charity may find that Mrs. X is displeased that her $1 million gift has been sold, and she's not too comfortable with people poking through her medical records and copying her physician's files.

Case 10: No Planning--a client viaticates for no apparent reason.

Example: Mr. Johnson, a 68-year-old man with terminal cancer, has a life expectancy of eight months. Four months ago, he viaticated a $200,000 life insurance policy, receiving a tax free settlement in the amount of $130,000. He now approaches his financial planner for advice on how best to invest this $130,000 so that it will provide a nice retirement fund for his surviving spouse.

Commentary: It would appear that Mr. Johnson has been sold a product he didn't need, and it will result in his surviving spouse having substantially less money for her living expenses. Had the client not viaticated, Mrs. Johnson would have had $200,000 in cash available eight months from now.

Case 11: Business Planning--key person insurance that is no longer needed.

Example: Several years ago, ABC Corp purchased a $1,000,000, 10-year term policy on the life of JR, a key executive. Earlier this year, JR retired and the company no longer needs the key person insurance. They could viaticate the policy and receive a cash settlement of $60,000.

Commentary: Business insurance that is no longer needed is often an excellent candidate for viatical settlements. These policies were usually purchased for a specific need and for a limited number of years. Before selling the contract, however, the company may want to offer the coverage to the retiring executive either for sale or as a retirement bonus. If JR's health has declined since the policy was purchased, he may want to convert the contract to permanent insurance for his own personal insurance needs.

As you can see from these case studies, while viatical settlements are not the universal planning panacea that their promoters claim, they can play an important, if somewhat limited, role in the planning process. Unfortunately, viatical settlement companies tend to hire inexperienced representatives to sell their products, and the analysis required to determine when this planning tool works best is often lost in the sales process.

Planning From An Investor's Point Of View

As the viatical settlement moves into mainstream planning, more and more of our clients will consider investing their own money in such ventures. Pick up any financial or senior magazine, and you'll find numerous advertisements promising safety of principal and guaranteed high yields.

Myth #6: Viatical investments are humanitarian in nature.

When viatical companies purchase policies from terminally ill insureds who desperately need money, this transaction offers an unparalleled benefit to those in need. Unfortunately, very few viatical companies focus on providing the dying with funds as much as they concentrate on making as high a profit as possible. One company advertises that their product serves an important social and humanitarian need to the terminally ill, and in the same sentence guarantees 80% returns to their investors. It is only by cheating these insureds out of a fair purchase price that they can offer such high yields.

Investors tend to feel a bit ghoulish capitalizing on the misfortune of others, and viatical companies often assuage this discomfort with promises of solving social needs. A viatical settlement is clearly a business arrangement and should be seen as such. There are numerous investors seeking to purchase policies, and only a small handful of viators looking to sell, so it is the economics of the seller's market, not humanitarian efforts, that will ensure that the terminally ill receive a fair payment.

Myth #7: Viatical settlement investments are as safe as CDs.

The viatical industry is largely unregulated, and promises made by the marketers are not subject to the scrutiny of the SEC or NASD. When investors see and hear advertisements in mainstream publications that these investments are completely safe and yet pay very high returns, they tend to believe it.

Even though this field is in its infancy, it is estimated that approximately $400 million has been lost so far in viatical scams. Investors assume that those marketing the ventures are regulated just like mutual fund companies and brokerage houses. They assume that their principal is insured by a government agency like the FDIC, and stories abound about elderly investors who withdraw their entire life savings from their CD accounts and invest with viatical companies who have been in business for less than six months, and who have made substantial promises they simply can't keep.

Investing in viatical settlements has numerous inherent risks, almost none of which are ever disclosed to the individual investor. For example, Mrs. Doe invested her entire life savings of $250,000 into a viatical settlement trust and was promised a guaranteed return of 15%. She was provided a health report for the insured whose policy she'd purchased, but had to trust that the underwriter who prepared that report was giving her an accurate estimate of the insured's life expectancy. She had been told that the insured would live for 12 months, but now, two years later, she has yet to see her investment pay off. She decided that she needed to withdraw some of her funds, but was informed that she could not do so without losing almost the entire investment to penalties. Just as she was starting to panic that she had lost her money, she received a bill for an additional required investment to pay the insurance premium on the policy she'd purchased.

While advertisements tout "an investment opportunity that is unaffected by the volatile stock market," "virtually unlimited profits," and "eliminates risk factors," the horror stories abound about investors who have been misled. Some purchased policies but were never named as the beneficiary of these contracts and therefore never collected. Others were the victims of scams where a terminally ill insured lied on his life insurance application in order to receive a preferred rating, and then viaticated shortly thereafter to collect a sizable settlement. If the investor purchases this policy during the two-year contestability period, it is likely that the insurance company may never pay the death benefit.

Investments in viatical settlements should not be considered safe, and should only be considered by those clients who have sufficient liquidity elsewhere and who completely understand the inherent risks.

Myth #8: Viatical settlement companies guarantee their returns.

This is one of the most misrepresented aspects of viatical investments. If you read through any major financial magazine, newspaper, or internet site, you'll see such promises as "15% guaranteed return," "we've eliminated the risk from viatical settlements and fully guarantee a 45% return," and "120% return, completely guaranteed." These advertisements are, of course, misleading and do not provide investors with sufficient information to understand the risks involved.

For example, an investor invests $70,000 to purchase a $100,000 policy on the life of an insured with 12 months to live. This is a 43% return. What the viatical company can't guarantee, however, is the actual life expectancy of the insured. If the viator lives five years instead of one, the annual return on the policy is substantially reduced. If the investor has to add additional funds to make unanticipated future premium payments, this too reduces the effective rate of return. If the insurance company declares insolvency or, as is quite likely in recent months, is acquired by another insurance company, the policy factors (credited interest rate, mortality charges, expenses) may be adjusted by the new company, resulting in unexpected cash required from the investor. The viatical company who sells these contracts can't control several factors in this process and their "guarantees" are meaningless.

Myth #9: You can invest your IRA assets in viatical settlements.

Many seniors hold a substantial percentage of their savings in IRA accounts and they have been targeted by several of the more aggressive viatical companies. The IRS is quite clear on this issue. It is a prohibited transaction to purchase life insurance with IRA funds. The penalty for doing so is the loss of tax free status of the plan, causing income tax to be due on the entire account in the year that insurance is purchased.

Viatical companies claim that they have circumvented this restriction because the IRA participants aren't purchasing a life insurance contract--they are purchasing an undivided interest in a pool of insurance contracts, similar to a limited partnership or mutual fund. At the same time, viatical companies are aggressively fighting off the attempts of the SEC and state securities departments to regulate these partnerships and funds as investments.

Currently, only a very small handful of IRA custodians will allow viatical investments, and these accounts usually require IRA participants to assume full liability. Until viatical settlements are recognized as regulated investments, or until there is precedence that the IRS will accept viatical investments in IRA accounts, clients should avoid such investments. The substantial penalties and risks do not justify the potential rewards.

Myth #10: The SEC has approved viatical settlements.

Viatical settlements are almost entirely unregulated at this time. While a few states currently have loosely defined insurance laws designed to protect viators, no state or federal securities laws currently exist to protect investors. No viatical settlement has been reviewed or approved by the SEC, and that agency has made it clear that they intend to target this industry in the future. There has been one major lawsuit to date in which the SEC lost their battle to call this arrangement an investment, but until such time as this controversy is cleared up, most broker/dealers in the nation are prohibiting their registered representatives from becoming involved in viatical investments.

Looking To The Future

The viatical settlement industry has boomed in recent years. As more and more investors seek high yield investments, there is a substantial shortage of insureds to meet this demand. If this continues, the yields will eventually be driven down as viators seek more competitive bids from a variety of companies. Many would say that the golden era of viatical settlements has already passed, and that the watered down opportunities and increased risks have now passed to the mainstream investor. Furthermore, as the industry increases in size and presence, future regulation is inevitable.

To meet the investor demand there is also a new trend towards insurance fraud. Unhealthy insureds are not disclosing serious illnesses on their life insurance applications, and once the policy is issued, they are viaticating for sizable settlements. This practice will most likely result in insurance companies becoming more diligent about medical underwriting practices. There is also concern among authorities that speculative investing on the lives of others could result in criminal activities such as murder.

On the more positive side of the industry, the viatical companies are becoming remarkably more sophisticated in their structure. When an investor purchases a contract, he/she will have to pay income taxes on the gain recognized when the insured dies. Under new arrangements, the insurance contracts are often pooled in partnerships or limited liability companies to qualify for one of the exemption for the transfer for value rules. While this structure is rather aggressive, it may result in the settlement profits passing tax free to investors.

And finally, it is too early to tell what the effect of the viatical industry will be on the life insurance marketplace in general. Most insurance companies rely on a certain number of insureds each year allowing their contracts to terminate. If a substantial number of these policies remain in force by being purchased by viatical companies, the insurance companies may need to substantially increase their policy fees and expenses to compensate.

Conclusion

Few industries have grown as quickly and with as much controversy as the viatical settlement marketplace. Considering that the target market for the various firms associated with this industry are the elderly and the dying, it is especially important that advisors practice due diligence and care in researching both the companies involved and the benefits promoted. For potential viators, all other options should be considered first, and all decisions should take into account the client's entire financial picture. For clients who are considering investing, only those who have the sophistication to understand the risks, and who do not require liquidity, should consider this investment.

I spend a lot of time educating individuals about the benefits and pitfalls of Viaticals and Life Settlements. It is not often I run across an article this comprehensive that I can share with potential customers.

Thank you for contributing to this small community of professionals that deal with these unique financial transactions.

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